Memories of the 28th Century

The Panic of 1907 may have been the deepest financial crisis that the U.S. faced except for the Crash of 1929. There was no central bank at that time, no bank of last resort, and for that reason the financial system completely stopped for a few days. The existing clearing system in New York City had to deal with numerous bank runs, and while banks were still clearing transactions, some of the trust companies were having more trouble. Trust companies were not part of the bank clearing system. The situation was turned around by J.P. Morgan and other NYC bankers who pooled available capital and kept the clearing bank in business and established a clearing bank for trust companies. There are many histories online and in print, so I won’t dwell on the details of which bank had a run which day. I think there were two remarkable things about that Panic.

The most remarkable thing about the Panic was that it was ended through the actions on one man, J. P. Morgan. The long term result of the panic was the creation of the Federal Reserve System, which because it is owned by the U.S. government put the government and the Treasury at the center of the banking system.

The Panic of 1907 was touched off by a speculator going under, but he, F. Augustus Heinze, controlled enough that his bankruptcy led to the bankruptcy of first a brokerage firm then a trust. The stock market started dropping, and it looked like there might be a domino effect, until J.P. Morgan stepped in. To make a long story short Morgan saved the U.S. economy, but read the Boston Fed link. The important thing was that it was done with little action by government at any level, but Morgan also placed a $30 million bond placement for the City of New York; thus saving the city from bankruptcy in addition to the U.S. economy.

Then let’s fast forward one hundred years to 2007 to the bank crisis of 2008. This crisis was caused by many people trying to make smart bets. The cleverest may have been “credit default swaps”. “A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer (the creditor of the reference loan) in the event of a loan default (by the debtor) or other credit event. The buyer of the CDS makes a series of payments (the CDS "fee" or "spread") to the seller and, in exchange, receives a payoff if the loan defaults.” (http://en.wikipedia.org/wiki/Credit_default_swap). AIG (American International Group) was particularly enthusiastic about CDS’s. They bought them for all of their debt and for the debts of everyone else they could think of, and they sold with as much zeal. Other financial companies were almost as wild about them. The panic of 2007 was set off by the sub-prime mortgage business unravelling. Banks and mortgage companies got people who couldn’t afford to buy a house to buy one with a very attractive rate and immediately sold the mortgage to consolidator that resold the mortgage as a bond that separated interest and principal. The banks, mortgage companies, brokers, and everyone involved was overextended, and the mortgages started to default. Seven years later it isn’t over yet, but most of the loans that the government gave to the speculators have been repaid. The big difference between this panic and 1907 is that the government was central to winding up the problems, and the people and companies that caused the problem were largely bailed out, while in 1907 the people who caused the problems lost everything.

I won’t flog this dead horse too much (actually, it is still with us.), but it is interesting to note the differences between a government bailout of guilty parties after the crisis of 2007-8 and the workout managed by J.P. Morgan in 1907. Morgan didn’t give anything to anyone; he arranged loans that were bought by others. A few banks did go under, but most were kept afloat by the clearing association, Morgan, and a few others. The biggest losers appear to have been stock speculators, who lost everything in some cases, but stocks were very speculative then.

The federal government paid out more than a trillion dollars to bailout those hurt by the panic on 2007-8. Money came from the Federal Reserve and from Congress. Most of the subprime mortgage companies were roll up into larger banks, and the biggest players, such as AIG were bailed out. The only companies that were liquidated were a couple of investment banks, most notably Bear Stearns Companies.

My conclusion in regard to these events are that all the government regulations and guarantees didn’t prevent a crisis that was very serious, and the government bailouts allowed some companies to rebuild at the public expense, but the public didn’t get anything for it and may have lost more as a result of the bailouts. The private arrangements that Morgan made ended the problem fairly quickly; the guilty lost a lot, while other lost little or nothings. The fallout was that Congress set up the Federal Reserve System in 1913, but the initial act did not include all of the powers that the fed has now; it was a clearing bank and lender of last resort without any power to regulate non-members.

Which situation was better? My personal opinion is that the Federal Reserve System should have fewer powers, and individual investors should be willing to accept losses.

Another great resource for this is Reminiscences of a Stock Operator by Edwin Lefèvre. This book is a fictionalized account of Jesse Livermore's activities in the securities markets. There are things in that book that you won't find mentioned in other histories of the securities industry, some of which are worth knowing.



History of Panic of 1907
https://www.bostonfed.org/about/pubs/panicof1.pdf
http://www.fas.harvard.edu/~histecon/crisis-next/1907/
http://www.thegoldstandardnow.org/the-panic-of-1907
Financial Crisis of 2007-8
http://en.wikipedia.org/wiki/Financi...007%E2%80%9308
Bailout act of 2008
http://en.wikipedia.org/wiki/Emergen...on_Act_of_2008

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